Rise of shell companies: Why tax authorities continue to wage a battle with them

September, 29th 2014

On March 16, 2012, then finance minister Pranab Mukherjee made his budget speech in parliament, like so many finance ministers had done before him, and as many will do in later years as well. However, that speech was to have one fairly unusual effect. In the two weeks following it, and before the beginning of the new financial year on April 1, thousands of small companies were incorporated across the country. ET Magazine estimates that the number of private limited companies formed in Kolkata alone, between March 16 and March 31, 2012, was around 3,173 (possibly more). The financial year which was to end two weeks after that budget speech was to set a record of sorts, with more companies being incorporated during that year than any other across India.

The Registrar of Companies (RoC) in West Bengal, under which companies domiciled in that state are incorporated, reported that 16,477 private limited, nongovernment owned companies were incorporated that year. Thus, a fifth of those were incorporated in just the last two weeks of March in Kolkata. On March 29 alone, around 416 companies were registered in Kolkata.

Why the sudden rush to incorporate so many new companies? And what purpose were these companies set up to serve?

Start-up TaxOne of the big highlights of Mukherjee's speech was what was to be later criticized as the startup tax. The FM had tightened income-tax laws that affect the way investors put money into new private limited companies. Any investments in those companies at a share price above what the law called 'fair market value' was to be treated as the income of the company and taxed. Little wonder then that start-ups and entrepreneurs were nervous as it was seen as hurting the flow of venture funding into new companies (however, the law did exempt investments by recognised venture funds).

In that respect the burst of new companies being formed seems perfectly understandable. Entrepreneurs rushed to incorporate new companies before April 1 to avoid being affected by the new law which would kick in on that date.

But this still left several questions unanswered, the main one being: Why Kolkata?

The city, known more for industries such as coal and steel, was hardly a thriving hub of start-up culture. And then there were other oddities. Of the 3,173 companies formed in those two weeks, around 294 were located in just one building, on one street in the city.

As an income-tax officer later termed it, those companies were a form of 'inventory' for an industry that is largely unknown, unless you happen to be an accountant, or a lawyer, or an executive wellversed in the ways that Corporate India manages money. Especially black money.

The Shell Company BusinessLast year ET Magazine had written about what is blandly called the 'accommodation entry' business, or, to give it its colloquial Kolkata name, the 'jamakharchi' business. It has been around in one form or the other for decades, but began to get organized and streamlined into what in management-speak would be called a 'scalable' business in Kolkata in the '80s. Since then it has spread to other cities. However, Kolkata, at least till a couple of years ago, was its epicentre.

The jamakharchi business exists for one big reason — to help its 'customers' convert black money into white, or vice versa. Given that unaccountedfor money is a part and parcel of how Corporate India operates, it raises the very immediate problem of how that black money is to be created and converted. On the one hand, large listed companies with foreign investors have to report audited accounts and ostensibly account for each rupee spent. On the other, while the companies may run perfectly legitimate businesses, they often have to deal with entities that aren't very transparent and which would prefer to be paid, or pay, in cash. And this is just those companies which don't want to evade any tax at all.

The 'jamakharchi' business exists to make such transactions happen by the tens, or even hundreds or thousands of crores. "It's important to point out that the jamakharchi business is, strictly speaking, not a money laundering business, though they share similar aspects," says the tax official ET Magazine spoke to. While money-laundering aims to convert money earned from criminal activity into legitimate income, the jamakharchi business may deal in unaccounted-for money earned as part of a perfectly legal business.

One of the more common ways to do this, till the change in tax law in 2012, was as follows. If a company had black money, which it wanted to channel as seemingly legitimate investments back into itself or group companies, it would get in touch with one of many 'accommodation entry' operators in the country. Some of the largest ones manage a portfolio of thousands of companies, either on their own, or through 'sub-operators' whom they habitually do business with.